Alternatives: Separating Fact From Fiction

Alternative investments have gained prominence over the past few years, especially as alternative mutual funds—also called liquid alternatives—made them accessible to a broader group of investors. Despite a rapid growth spurt, alternative strategies still seem shrouded in mystery. Let’s separate fact from fiction.

Fiction: Alternative investments are a new innovation.

Fact: Alternative investments date back to 1949, when Alfred Winslow Jones developed the first known alternative strategy. As a sociologist and financial editor, he was interested in protecting investors from market instability and started the evolution we see today. His idea combined two approaches:

Selling significantly overvalued stocks “short” that were expected to fall in price.

Thus, the long/short equity strategy—still one of the most common alternative approaches—was born. Alternative investments now make up over 50 percent of a typical institutional endowment and foundation’s portfolio.1 Alternative mutual funds have begun to make their way into individual investors’ portfolios, building on many of the approaches that have been available only to high-net-worth or institutional investors for decades.

Fiction: Investing in alternatives have increased portfolio risks.

Fact: Over the last 20 years, alternatives have shown to have less risk than stocks when comparing volatility, which is measured by standard deviation. Usually, the higher the volatility, the riskier the investment. This chart compares them to traditional investments from January 1997 to December 2016.

Return

Volatility

Bonds

5.3%

3.4%

U.S. Stocks

7.7%

15.3%

Alternatives

6.9%

6.9%

Source: Morningstar Direct. Bonds are represented by the Barclay’s US Aggregate Bond Index,2 Equities are represented by the S&P 500, and Alternatives are represented by HFRI Weighted Composite Index.3

Alternatives offered lower returns than stocks. However, they had more than 50 percent less volatility. They have also been more resilient during severely negative market events, such as the global financial crisis that ran from December 2007 through February 2009. During that time, stocks suffered a nearly 50 percent drop, compared to alternatives, which experienced a 20 percent loss.4

Why is this important? First, striving to hedge against large downturns may help make it easier to reach your goals. One reason is because when you experience a loss, you need time and larger gains to get back to your original portfolio balance before the loss. Using only bonds may not help you recover the loss either. While bonds are historically less risky, it may be difficult for them to achieve the same returns they have offered during the last 20 years with ten-year interest rates hovering just over two percent. Lower returns will cause your portfolio to need more time to recover the loss from a severe market drop.

Like any investment, there are risks when adding alternatives to a traditional stock and bond portfolio. However, the risks are related to more advanced and complex strategies alternative managers use, which are not found with traditional investments.

Fiction: Alternatives are too confusing and complex.

Fact: Alternative strategies build on asset classes and structures you may already be familiar with. For decades, sophisticated institutional investors relied on alternative investments, primarily through hedge funds and private investments, to construct diversified, outcome-oriented portfolios. These investments had drawbacks. Not only did they usually require a certain asset level and a lock-up period in which investors aren’t allowed to redeem or sell shares, but they also often charge management fees and layer on additional performance fees.

Alternative mutual funds have improved access, with many offering strategies similar to hedge funds. However, alternative mutual funds are regulated like traditional stock and bond funds, and cannot charge performance fees. They offer daily liquidity and transparency into their holdings and performance, just like a traditional mutual fund.

Fiction: Any alternative investment will enhance diversification.

Fact: Some investors, and even advisors, think adding an alternative investment to a portfolio can help them check the box for diversification. That’s not true for traditional investments or for adding alternatives. Like traditional investments, alternatives come in all shapes and sizes, and it’s important to understand how pairing different strategies may work together for the good of the portfolio.

In addition, results of individual managers can vary greatly—even within a strategy. This occurs because alternative investment fund managers do not try to match an index, but instead rely on their skill as managers. They often have more flexibility to invest in different asset classes and instrument types globally, and also have the ability to use long and short strategies.

Conversely, traditional stock and bond mutual funds display relatively small variation among funds, primarily because many are managed to match, or beat, a specific benchmark and do not have the same flexibility in their trading strategies.

Alternative mutual funds often hold a variety of non-traditional investments, and may employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies has unique risks, making them more suitable for investors with an above average tolerance for risk.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Diversification does not assure a profit nor does it protect against loss of principal.

The opinions expressed are those of Cleo Chang and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.

1Source: National Association of Collegiate and University Business Officers (NACUYBO), 2016

2Barclays U.S. Aggregate Bond Index represents securities that are taxable, registered with the Securities and Exchange Commission, and U.S. dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities.

3HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to the HFR Database. Constituent funds report monthly net of all fees performance in U.S. Dollar and have a minimum of $50 million under management or a 12-month track record of active performance. It does not include Fund of Hedge Funds.

4Sources: Morningstar Direct, Hedge Fund Research (HFR) and FactSet. December 2007 to February 2009.

Cleo Chang is senior vice president and head of alternative investments at American Century Investments. She helps develop competitive and forward-looking proprietary investment capabilities and serves as the company's thought leader on alternative strategies. If Cleo wasn't a portfolio manager, she would own a bakery -- because every town needs one!

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